Buy High, Sell Low Part Three

A Simple, Proven Cash Flow Investing Strategy

D. M. LukasThis is the third and final installment in our Cash Flow Investing Series.  In the last article we detailed the 2 types of trades that you will be using in the Cash Flow Investing Strategy.

 

The first type of trade we will use is selling “covered calls” on the stocks that we own to provide a consistent cash flow.  The second, type of trade that we will use is “selling puts” on stocks that we want to own at a lower price.

 

In this article, we are going to cover a few examples of how to manage these trades depending on what the stocks that you are playing this strategy with are doing.

 

Trade Management #1:  Covered Calls

 

In the last article I used the following example:

 

Using the example of Halliburton from our first article, let’s say, I purchased the stock at $34 and after checking the options chains at 3 mos and 6 mos out, I see that the 36 call 3 months from now is selling for $3 per share.  I could sell that strike and would pocket $300 right now, about a 9% return on my money…in just 3 months!

 

Imagine if you did that 4 times per year!  You would have a whopping 36% return on your money!

 

So, what happens in 3 months, if Halliburton is at 36 or  higher?  Even better!  Now in addition to the $300 I made, I will make an additional $200 (I owned one hundred shares at $34 and it is now $36 or greater.  The call was for $36, so they would pay me $36 and take the shares).  That is $500 in 3 months or approximately a 15% return on my money.  No bad, huh?

 

You are probably thinking, “That’s great, but what if Halliburton drops like a brick?”  Well, that is equally as good for us.  I will explain more about what to do if your stock drops in our next and last article.  Just always remember, that movement = opportunity.

 

As you can see from the example, if you sell the covered call on Halliburton and it is at or above that call strike on the expiration date, then there is nothing you need to do as they will take your shares from you at the higher price, giving you more return ($500 from above).  Great!  Turn around purchase 100 more shares and “lather, rinse, and repeat” or purchase another one of your chosen stocks and do it with that one.  Also, if the price is below the strike (in this case $36), you get to keep the original money ($300) and the stock and turn around and sell again!

 

But what happens as in the bottom part of the example if you purchase Halliburton at $34, sell the $36 call, pick up the $300, and then Halliburton drops to $29?  If you think about it, by being paid the $300, you actually reduced your cost basis on the stock from $34 to $31 (100 shares x $34 = $3400 -$300 (call sale) =$31).  That means your “breakeven” price is now $31, so at $29 you are losing $200 on paper.  At this point, you have a few choices:

  1. First, you can just leave it alone, especially if it is in the first 2-4 weeks of the trade.  Your call period is for 3 months and as you probably know stocks fluctuate up and down every day.   Halliburton could go up to $33 tomorrow.
  2. If you are in the later stages of the call period (maybe a couple weeks to go before expiration), you could simply buy the call back and then resell another one 3-6 months out, reducing your “breakeven price” further.
    1. The beauty of options is that they have a time limit, so the closer you get to expiration, if the call is not near the price you sold it for ($36), then it will lose value and the price will go down.  For example, you had sold the call for $3 and picked up $300 in your account.  If you are 2 weeks from expiration and Halliburton is at $29, the market will price in the fact, that the chance for it to hit $36 is low and thus the call will go down in price, so instead of $3, it may only be $.50.  Great!  That means that you can buy back the $36 call for $50, keep $250, and then turn around sell another one 3-6 months out and pick up another $300 or more.
    2. In this case, you breakeven cost is now $31.50 ($34 per share -$2.50 you kept after buying the call cheaper), so  if the stock is at $29, you would want to sell your next round of calls at or above your breakeven ($32) or above.  This works perfectly as you are only a couple strikes away from the $32.
    3. You can do the same thing over and over again as the stock stays the same or goes down some…continue to buy and resell and lower your breakeven.
    4. Eventually you will hit a point where the money you have collected from buying and reselling pays the original stock purchase costs ($3400) and you are playing with the “house’s money” and not your own.
  3. What happens if you buy the stock and sell the call today and tomorrow it drops immediately?
    1. Same strategy as above only you get to do it sooner!
    2. You can simply buy the call back for a lower price and resell another one or you can do what I do…
      1.  I know that stocks fluctuate, so movement = opportunity
      2.  If I made the trade and this happened to me.  I typically will buy the call back and wait for the stock to go back up (usually in a matter of days) and then I will resell the strikes again and pick up more money!
      3.  If you have the time to watch things closely, many times you can do this multiple times a month and make exponential returns!

 

 

Trade Management #2: Selling Naked Puts

 

In the last article I described selling puts and gave an example in the following way:

 

The way you sell a put is simply to look 3-6 mos out in the put options chain on a stock you would like to own and then “sell” the option at a lower price and get paid the option price.  Sticking with our example of Halliburton from the first article, the stock is at $34, but the $30 put 3 months out is selling for $2 per share.  Halliburton is a great buy at $30, you be happy to own it if it came down that low.  So, you “sell” the January 30 put strike.  Immediately 2 things happen, you get paid $200 or approx. 7%.  Remember, if you had to buy the stock it would be at $30, not $34 (so $200/$3000 is about 7%).  The second thing that happens is that the $3000 is set aside in your account by your brokerage firm to cover you buying the stock if it got down to $30 by January.

 

That is one reason why I state at the beginning of this series that this trading style is not for everyone.  It will work for anyone, but only some have the money to be able to do this on a large scale.  You can, however, start out just doing either strategy on 1 stock and create the income to do either strategy on your next stock, and so on.  Again, this is a long-term, steady cash flow way to invest.

 

So, what happens if you get “put” the stock or even more importantly, if the stock drops below the price you sold the put at?

 

 

In this example, if you sold the put at $30 and picked up the $200 and 3 months later the stock is above $30, you get to keep the $200 and  your $3000 set aside in your brokerage account is now freed up to sell another put!

But what happens as in the bottom part of the example where you get “put” the stock or even more importantly, the stock drops below $30 at expiration?

Well, there are few things. 

  1. First and foremost, remember, just like in our call example above, by initially getting $200 or $2 per share, we have reduced our breakeven on the stock to $28 ($30 per share put strike -$2 =$28).  So we could actually get “put” the stock at $28 per share and we are at breakeven.  Great!  Now that we own it, we turn around and sell a covered call on it picking up more cash!  From there we can follow the management techniques described in the call section above.
  2. What happens if it is at $26?  Same thing as above, you will get put the stock and now you can sell calls and pick up some cash to bring you to breakeven.  Just be conscious that your breakeven is at $28, so you will want to sell your call at or above that strike.  Also, remember that the cash you get from that sale will reduce your breakeven amount as you are getting paid again.

Stop here for second.  Do you see how over time you actually can use this strategy with both trade types to pay yourself back what you paid originally to buy the shares?  It is so awesome when over time, you pay yourself completely back from these trades and again, and are playing with the “house’s money!”

Another thought:

Patience is very important. People are always anxious once they get “put” stocks to turn around and sell the calls right away.  We discussed at the beginning of this article series that you need to pick stocks that you are willing own for a long time and I talked before about how stocks fluctuate.  If a stock has come down so far that you are going to get “put” the stock or it is lower than your put strike, it means that stock has had significant movement to the downside. 

Don’t think that other people haven’t noticed and aren’t thinking it is a great buy at those levels as well.  Why? Because as we have discussed when you are initially picking your stocks, they are good stocks, with good track records, probably dividend payers, so people will take the opportunity to scoop up the shares. 

If you are willing to wait a little while (typically within a week), the stocks will go up and you can sell your call strikes at an even higher price allowing you the chance to not only get paid on the calls, but also get taken out (in the future) at a potentially even higher strike price making more money than if you have sold right away.  I have done this many times after getting “put” stocks and the patience has helped me as I am able to get the same call amount paid to me, but usually 1-2 strikes higher!

 

Well, there you go.  A simple Cash Flow Investing strategy to help you build wealth consistently over time.  Keep in mind that this is a very basic description of this strategy and is meant to inform you of what is available out there for you to do.  It is not financial advice.  There are many other tactics and management techniques that you can learn to help you make this strategy even more effective.  In the future, we will be releasing a detailed program that shows you step by step how to do this strategy complete with video tutorials, necessary tools to help you, and complete management techniques.  Until then, if this strategy appeals to you, start employing some of the thoughts from this article and “paper trade” or trade in a play money or fake account to test it out and develop your own strategies of Cash Flow Investing.

About the Author Brian Keith

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